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Ricardian Model
Opportunity costs and comparative advantage An Example Relative demand-relative supply analysis A one factor Ricardian model Production possibilities Gains from trade Wages and trade Misconceptions about comparative advantage Transportation costs and non-traded goods Empirical evidence
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Introduction
Theories of why trade occurs can be grouped into three categories: Market size and distance between markets determine how much countries buy and sell. These transactions benefit both buyers and sellers. Differences in labor, physical capital, natural resources and technology create productive advantages for countries. Economies of scale (larger is more efficient) create productive advantages for countries.
Introduction (cont.)
The Ricardian model (chapter 3) says differences in productivity of labor between countries cause productive differences, leading to gains from trade.
Differences in productivity are usually explained by differences in technology.
The Heckscher-Ohlin model (chapter 4) says differences in labor, labor skills, physical capital and land between countries cause productive differences, leading to gains from trade.
An Example
China
can produce 4,000 wine/hour or Can produce 1,333 cheese/hour o.c. of 1 cheese is 3 wine o.c. 1 unit of wine is 0.333 cheese
Opportunity cost of One wine China 1/3 cheese 3 cheese one cheese 3 wine
Montenegro
can produce 1,333 wine/hour or can produce 4,000 cheese/hour o.c. of 1 cheese is 0.333 wine oc. of 1 unit of wine is 3 cheese
Montenegro
1/3 wine
An Example (cont)
5 4 3 2 1
Montenegros PPF Chinas PPF
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An Example (cont)
cheese (thousands per hour)
5 4 b' 3 2 1 a
Chinas PPF
Chinas opportunity cost: 1 wine costs 1/3 cheese, and 1 cheese costs 3 wine Montenegros opportunity cost: 1 wine costs 3 cheese, and 1 cheese costs 1/3 wine
c
Montenegros PPF
b 1 2 3 4
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An Example (cont.)
China has comparative advantage in producing wine, and Montenegro has c.a. in producing cheese. China specializes in wine production and Montenegro in cheese production. Both countries are better off by engaging in international trade!
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An Example (cont)
Chinathe country with absolute cost disadvantagecan benefit from trade Montenegrothe country with absolute cost advantagecan benefit from trade too But how much exactly do they produce? At what prices?
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Dc, Sc The two markets in the home country; there are two markets in the foreign country
Dw, Sw
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Hence, we dont need two separate diagrams for the home country We just need to look at one relative demandrelative supply diagram
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Demand
Assume identical, homothetic preferences Each consumers relative demand depends only on relative price, and not on her income level Given the relative price, each consumers relative demand is determined, so is that of the whole population One example is CobbDouglas utility function Qw I=PcQc+PwQw I>I
I=PcQc+PwQw Qc
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Relative Demand
Pc/Pw
Qc E 1 ! Qw 1 E ( Pc / Pw )
High
Relative demand by a single consumer =Relative demand by the whole country =Relative demand by the whole world
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Relative Supply
Assume that we are dealing with an economy (which we call Home). In this economy:
Labor is the only factor of production. Only two goods (say wine and cheese) are produced. The supply of labor is fixed in each country. The productivity of labor in each good is fixed (c.r.t.s. technology).
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A One-Factor Economy
The unit labor requirement is the number of hours of labor required to produce one unit of output.
Denote with aLW the unit labor requirement for wine (e.g. if aLW = 2, then one needs 2 hours of labor to produce one gallon of wine). Denote with aLC the unit labor requirement for cheese (e.g. if aLC = 1, then one needs 1 hour of labor to produce a pound of cheese).
The economys total resources are defined as L, the total labor supply (e.g. if L = 120, then this economy is endowed with 120 hours of labor or 120 workers).
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aLC/aLW
RS
RD (low )
RD (high )
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Home has a comparative advantage in cheese and will export it to Foreign in exchange for wine.
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a*LC/a*LW
RS
aLC/aLW
L/aLC L*/a*LW
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Trade Equilibrium
Relative price of cheese, PC/PW Autarky equil for Foreign a*LC/a*LW Trade equil 2 Autarky equil for Home RD L/aLC L*/a*LW RS
aLC/aLW
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F Quantity of cheese, QC
P*
T*
(a) Home
(b) Foreign
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A Quantity of cheese, QC
Trade moves Home countrys consumption bundle from A to B, surely an improvement! A similar conclusion for Foreign country.
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(a) Home
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Incomplete specialization
If 1/9, then Home has incomplete specialization, it is neither better off nor worse off under trade. But Foreign still has complete specialization and is still strictly better off If 1/3, then Foreign has incomplete specialization, it is neither better off nor worse off under trade. But Home is still better off
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Incomplete Specialization
Relative price of cheese, PC/PW If is low enough, there will be incomplete specialization by Home.
RS
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Wages
Relative Wages
Because there are technological differences between the two countries, trade in goods does not make the wages equal across the two countries. A country with absolute advantage in both goods will enjoy a higher wage after trade.
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Wages
This can be illustrated with the help of a numerical example:
Assume that PC = $12 and that PW = $12. Therefore, we have PC / PW = 1. Since Home specializes in cheese after trade, its wage will be (1/aLC)PC = ( 1/4)$12 = $3. Since Foreign specializes in wine after trade, its wage will be (1/a*LW) PW = (1/1)$12 = $12. Therefore the relative wage of Home will be $3/$12 = 1/4. Thus, the country with the higher absolute advantage will enjoy a higher wage after trade.
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4 3 2 0.75
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Empirical Evidence
Do countries export those goods in which their productivity is relatively high? The ratio of US to British exports in 1951 compared to the ratio of US to British labor productivity in 26 manufacturing industries suggests yes. At this time the US had an absolute advantage in all 26 industries, yet the ratio of exports was low in the least productive sectors of the US.
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Summary
1. A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries.
A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods.
2. The Ricardian model focuses only on differences in the productivity of labor across countries, and it explains gains from trade using the concept of comparative advantage.
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Summary (cont.)
3. When countries specialize and trade according to the Ricardian model; the relative price of the produced good rises, income for workers rises and imported goods are less expensive for consumers. Trade is predicted to benefit both high productivity and low productivity countries, although trade may change the distribution of income within countries. High productivity or low wages give countries a cost advantage that allow them to produce efficiently.
4.
5.
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Summary (cont.)
7. Although empirical evidence supports trade based on comparative advantage, transportation costs and other factors prevent complete specialization in production.
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